Vulture funds have been described by the worst of terms. They have been described as funds that pounce on a state like a vulture on a rotting carcass. Vulture funds are exploitative financial funds in which a private fund buys up cheap foreign debt, and sells it at a much higher cost.

Vultures have been used to describe all types of financial ventures involving debt, not just sovereign debt. For example, corporate vulture funds have raised US$15.6 billion in the first seven months of 2007. Even mainstream investment banks such as Goldman Sachs have become involved, as they have put together nearly US$20-30 billion worth of funds.

The Basics of a Vulture Fund

A vulture fund is a fund or investment company that purchases debt claims as a secondary lender. This means that vulture funds are not primary lenders, but rather are entities that have purchased the debt from some other source, such as a bank. Generally, these funds purchase debt involving highly distressed countries. The sellers of these debts usually are more than willing to rid themselves of these debts because many of these debts may soon come into default or face restructuring negotiations. Thus, the vulture funds purchase this debt as it is about to be written off. (Banks will write off loans as a loss if they believe that the borrower will no longer be able to repay the loans.) Then, the vultures sue the debtor or borrower for the full value of the debt, plus interest. The lawsuits occur in national courts, often in the United States, Paris, or Brussels. Through litigation and negotiation, vulture funds have been able to secure a payout greater than the cost of the vulture's purchase.

The Use of Litigation to Enforce Debts

One of the primary reasons why vulture funds are successful is because courts have been willing to enforce a vulture fund's right to collect the full value of the debt. Nations such as Zambia, Peru, Argentina, etc., have lost lawsuits to vulture funds.

One of the primary and highly successful arguments justifying full enforcement is the inclusion of a standard “pari passu" clause in many sovereign debt agreements. Pari passu clauses require that all creditors be treated equally. Accordingly, a prominent Brussels court has held that pari passu clauses forbid states from paying only the restructured portion (as explained below) without paying the vultures as well. Therefore, if there is not enough money to go around, all creditors receive a pro-rata share and debtors are not allowed to pay off one creditor in full while leaving others unpaid. Because these clauses contractually prohibit a state from paying off one creditor before other holdouts, these clauses can act as a “large hammer" in the hands of holdout creditors. This has the effect of either forcing states to appeal court decisions that stop the restructuring because of the pari passu clause, or pay up in a settlement agreement with the vulture fund so that debt restructuring can take place.

The Holdout Creditor's Hammer to Impede Debt Restructuring

The hammer referred to above references the power a holdout may have over a sovereign debt restructuring process. Debt restructuring often is an effective means to alleviate some of the national debt load without going into default, and restructuring debt can promote a sustainable debt service load. This frees up funds for domestic development. Restructuring often results in payments of less than the face value of the debt. However, the threat of successful litigation by a holdout can impede a successful restructuring process. Depending on how much debt a vulture fund owns relative to the total restructuring, a refusal to participate in the restructuring by the vulture fund could complicate the entire restructuring process. Such holdouts can be a primary barrier to orderly sovereign debt restructurings.

The hammer wields its power because of the pari passu clause. The pari passu clause, as stated above, contractually bars a state from paying off the restructured debt prior to paying off a vulture fund. Thus, the prospect of a holdout may discourage creditors from agreeing to a restructuring, because (1) creditors now can collect the full amount of the debt by suing, and (2) restructuring may be stopped by the courts under the pari passu argument.

Even if a country chooses to restructure its debts despite the vulture's threat of litigation, vulture funds have been successful in their use of courts to stop payments to creditors under the restructuring agreement. For example, a court stopped Peru from paying off some of its bondholders because the pari passu clause prevented Peru from paying off other debts without also paying off the vulture fund.

Therefore, unless holdouts are paid, they may be able to call for a default for nonpayment. For example, in Peru (which will be discussed in further detail below), the vulture fund stopped Peru from making a payment to other creditors. If a state chooses not to pay the vulture fund, that fund could call a default. On the other hand, when the state is prevented from paying the other creditors by a vulture fund, those other creditors may call for a default. This likelihood of default may prompt a rush to grab the sovereign's limited foreign exchange reserves, as creditors will attempt to get at whatever they can before a state goes into default. Most importantly, the ability to call a default by a vulture fund can trigger cross-default clauses in other debts. This may result in a massive default that will ultimately impede restructuring. Thus, the pari passu clause, which prevents a state from paying off restructured debt prior to the vulture fund, is an effective hammer utilized by vulture funds to gain full (or nearly full) payout. As one scholar writes, “[t]hose inclined to be holdouts have a stronger position, and it encourages others to hold out. For the sovereigns… this is a nightmarish situation. The result is likely to be that the threat [of a lawsuit] will force sovereigns in distress to turn to more extreme forms of renegotiation." Ultimately, this prevents an orderly restructuring that would benefit the people of the debtor country. Vulture funds then, result in more monies going to pay off sovereign debts instead of being used for badly needed domestic development programs.